Are you new to self-employment? Working for yourself doesn't mean you must forego tax-advantaged retirement savings. In addition to contributing to a traditional IRA, there are two basic retirement plan options that may make sense for self-employed individuals: Simplified Employee Pensions (SEPs) and SIMPLE IRAs. Here are the pros and cons of these plans.
Important: For purposes of this article, the term "self-employed" means you're a sole proprietor, the sole owner of a single-member limited liability company (LLC) that's treated as a sole proprietorship for tax purposes, a partner or a member of a multi-member LLC that's treated as a partnership for tax purposes.
Option 1: SEPs
SEPs are stripped-down retirement plans mainly intended for the self-employed. In effect, a SEP is a defined-contribution plan. As such, the maximum deductible contribution for the 2022 tax year is $61,000. But your contribution is limited to 20% of net self-employment (SE) income reduced by the deduction for half of your self-employment tax (SE tax).
So, the maximum deductible SEP contribution for the 2022 tax year is the lesser of:
$61,000, or
20% of net SE income from Schedule C of your Form 1040 or Schedule K-1 if you're a partner or an LLC member treated as a partner reduced by the deduction for half of your SE tax.
There are several key advantages to using a SEP:
If you have a healthy amount of SE income, you can make large annual deductible SEP contributions — potentially up to $61,000 for the 2022 tax year. With that said, you would need at least $305,000 of net SE income to claim the maximum deduction (20% of $305,000 is $61,000).
There's no requirement to contribute anything for a particular year. So, in years when cash is tight, you can contribute a small amount or nothing. In years when you're flush, you can contribute the maximum allowable amount.
For a one-person business, a SEP is easy to set up with the help of your financial and tax advisor. The required paperwork can be completed in a few minutes.
You can establish a SEP and fund the account as late as the extended due date of the Form 1040 for the year in which the initial deduction is claimed. For example, if you're a sole proprietor who extends your calendar-year 2022 Form 1040 to October 17, 2023, you have until that date to establish the SEP and make the initial contribution, which you can then deduct on your 2022 Form 1040. On the other hand, you can establish and fund your SEP anytime between now and then if you extend your 2022 return.
Plus, once your SEP is established, there are essentially no administrative details to worry about. But there are also some downsides to consider. For example, if you have one or more employees, annual employer SEP contributions may be required for any employee who 1) is at least age 21, 2) has worked for you during at least three of the past five years, and 3) receives at least $650 of compensation.
Because all employer contributions vest immediately, an employee can leave at any time without losing any of his or her SEP money. For that reason, SEPs generally aren't a great idea for businesses with more than a few trusted employees. Contributions on behalf of employees are deductible by you, as the employer. In addition, some other types of plans may permit larger contributions, depending on your circumstances.
Bottom line: Because of their simplicity and flexibility, SEPs are often the best choice when only you, the self-employed business owner, will be covered by a tax-advantaged retirement plan.
Option 2: SIMPLE IRAs
As a self-employed small business owner, you can set up a SIMPLE IRA plan. For the 2022 tax year, you can make a deductible contribution of up to $14,000 of net SE income to your SIMPLE IRA account. In addition, you can make a so-called "matching contribution" of up to 3% of SE income.
When you have only a modest amount of net SE income, the maximum deductible contribution to a SIMPLE IRA may be considerably larger than what would be allowed under the other tax-advantaged retirement plan flavors.
For example, suppose you'll have $40,000 of net SE income for 2022. You can make combined deductible contributions of up to $15,200 for the 2022 tax year: $14,000 plus $1,200 matching contribution (3% times $40,000). In contrast, the most you could contribute to a SEP would be only $8,000 (20% times $40,000).
For the 2022 tax year, an additional "catch-up" contribution of up to $3,000 is allowed if you'll be 50 or older as of December 31, 2022. So, if the person in the previous example will be 50 or older by year end, he or she could contribute up to $18,200 for the 2022 tax year.
Like with a SEP, contributions to a SIMPLE-IRA are completely discretionary. A SIMPLE IRA is easy to set up using plan documents that your tax and financial advisors can provide, and you're not required to file any annual reports with the government.
But there are some downsides to choosing a SIMPLE IRA, including:
You must set up a SIMPLE IRA by October 1 of the year for which you want to make your initial deductible contribution. So, if you want to make a contribution for the 2022 tax year, you've got to make your move by no later than October 1, 2022. However, the contribution itself can be made as late as the extended due date of your 2022 Form 1040.
If you have employees, contributions may have to be made for them, and those contributions become 100% vested immediately.
Other types of plans allow larger annual deductible contributions to your account if you have significant SE income. For instance, with a SEP, you could contribute up to $61,000 for the 2022 tax year if you have net SE income of $305,000 or more this year.
Bottom line: If you want to maximize annual deductible contributions, a SIMPLE IRA can be considerably the best retirement plan option when your business generates only a modest amount of SE income. If you're 50 or older, you can make additional catch-up contributions to sweeten the tax-saving deal.
Keep It Simple … For Now
If you're new to the world of self-employment, it's easy to become intimidated by the menu of tax-advantaged retirement plan options. SEP and SIMPLE-IRA retirement plan options are two options that are easy to set up and administer. As your business grows, you might consider switching to a more sophisticated retirement plan alternative that can allow bigger annual deductible contributions. Contact your tax and financial advisor to determine what's right for your situation.
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